Claire Corlett

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What Is the Fisher Effect?

What Is the Fisher Effect?

♪ [music] ♪ – [Narrator] What is
the Fisher effect? The Fisher effect describes
the relationship between the inflation rate
and the nominal interest rate. Suppose your grandma lends you $100
at an interest rate of 10%. That’s right, this grandma
has an interest rate. But suppose also that over the year
the inflation rate is 10%. So at the end of the year,
you pay your grandma back $110. That looks pretty good on paper,
but during that year, money has become less valuable. Due to inflation,
what used to cost $100 now costs $110. So what’s your grandma’s
real return? Zero. More generally, we can write
that the real interest rate is equal to the nominal rate,
the rate charged on paper, minus the inflation rate. Inflation reduces
the real return on a loan. So if grandma expected
the inflation rate to be 10%, then in order to get a real return
of 5%, she must charge you a nominal interest rate of 15%. Now you make think Grandma’s cold
for charging you a 15% interest rate, but she isn’t alone
in this behavior. Everyone does it,
and it’s called the Fisher effect, named after the great American
economist Irving Fisher. The Fisher effect observes
that nominal interest rates will rise with expected
inflation rates. We can see the Fisher effect
in this data from the United States. Notice for example how
interest rates and inflation rates were low in the 1960s,
but as inflation increased so did interest rates. Interest rates reached a peak
of almost 20% when inflation hit 15% per year. Since that time,
inflation has fallen, and so have interest rates. So to recap, the Fisher effect
describes how interest rates and expected inflation rates
move in tandem. To learn more about
what causes inflation, click here. Or, to test your knowledge
on the Fisher effect, click here. ♪ [music] ♪ Still here? Check out Marginal Revolution
University’s other popular videos.

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